There was some initial relief that the U.S. July inflation data released last week revealed a modest deceleration in the core number to +4.3% (chart below). However, a closer look at the underlying data and other recently released inflation data will question how much longer the term ‘transitory’ can be used by monetary authorities before credibility is damaged.

Source: Strategas Research Partners

THE INFLATION & CONSUMER PRICES

The transitory inflation view rests on the observation that, so far, U.S. consumer price surges have been tied to “re-open” sectors (cars, hotels, travel). These price surges should subside as capacity ramps up to meet demand. Proponents of this view have argued that once this surge in prices does not spread to the more important and sticky wage and rent components of the inflation measures then all would be fine – long-term inflation expectations would remain anchored. This argument is starting to come under pressure. Underlying data is showing that rent inflation has finally started to turn upwards (chart below). This should not be surprising given the surge in residential house prices (not included in official inflation calculations) and the strong recovery in the labour market.

Source: Strategas Research Partners

The chart below shows the sustained rise in medium-term inflation expectations during the past 18 months on the back of emergency monetary and fiscal stimulative measures. How credible is it to talk of transitory inflation when three-year expectations are almost double the official inflation target of 2%? If these expectations prove close to reality, then how long can U.S. 10-year bond yields remain below 1.5%?

Source: Strategas Research Partners

CONSUMER CONFIDENCE

It is also becoming clear that inflation is starting to bite and is having a tangible impact on consumer sentiment. The University of Michigan survey of consumer confidence plunged in early August. The expectations component of the survey (first chart below) made a new post-pandemic low. This decline in consumer confidence can be traced to multiple factors. However, the single largest factor must be the ongoing decline in real wages (second chart below). Wages do continue to increase but have not been able to keep pace with the rapid rise in general inflation, thereby reducing the purchasing power of many consumers. If the previously discussed inflation pressures do not ease, it is a matter of time before it will be reflected in increased wage demands. Global bond yields have responded to the most recent data by moving higher though still remaining well below their 2021 highs.

Source: Strategas Research Partners

Source: Strategas Research Partners

SECULAR CONTRACTION

In a significant reversal from previous years, equity market gains in 2021 have been led by the strong earnings recovery, even as elevated valuation multiples have begun to compress (chart below). This multiple compression is a natural development coming out of economic recession and depressed corporate profitability. However, the probability of a secular contraction phase still appears to be increasing. In the U.S. the prospect for higher taxes to pay for the excessive fiscal outlays, a pick-up in inflation, and a possible rising rate environment are all secular headwinds for multiples.

Source: Strategas Research Partners

It does seem likely that earnings growth and dividend payouts will constitute ever more important determinants of equity performance as opposed to multiple expansion. In this context European equity markets do appear more attractive. Valuation multiples in Europe, while above historical averages, are not as stretched when compared to the U.S. market. On the economic front, the recovery process has lagged but is now gaining momentum and should support further gains in corporate profits. While the earnings recovery in the U.S. continues with the NTM EPS (next 12 months earnings) well above the pre-covid levels, the story in Europe has been different. The earnings recovery has taken longer to materialize, with the NTM EPS figure only recently surpassing the pre-covid levels (chart below). This delayed earnings recovery may mean that European stocks could outpace U.S. peers in the near term led by better earnings momentum and a more supportive monetary and economic backdrop.

Source: Strategas Research Partners